Personal Investing 101

1. By Curtis Gary Dean FCAS, CFA, ChFC Distinguished Professor of Actuarial Science, Ball State University Personal Investing 101

2. You’ve Heard It Before • Information is not new. Repeated again and again. • Even so, most of you have no strategy or an inferior strategy. • You can beat most investors by wide margin by following a very simple plan.

3. Average Annual Returns: 1926-2002

4. Compound Growth • Stocks: $10,000 x (1.1019)30 = $183,766 • Bonds: $10,000 x (1.0588)30 = $55,516 • T-bills: $10,000 x (1.0379)30 = $30,526 • Stocks may not be quite as dominant in future, but still best bet for long-term growth.

5. Fundamental Principles • Identify goals and select appropriate investments. • Diversify. • Defer taxes. Keep turnover low. • Keep investing expenses low. Make yourself rich, not the brokers. • Make a plan and stick to it. Do not chase yesterday’s winners.

6. Identify goals and select appropriate investments • Short-term goals: money market, certificates of deposit, short-term bonds • Long-term goals: inflation-protected bonds, intermediate-term bonds, real estate, stocks

7. Diversify • Across asset classes: money market, bonds, real estate, stocks • Within asset classes • Bonds: municipal, U.S. govt, corporate, mortgage-backed, inflation-protected • Stocks: industry, company size, value and growth, domestic and international

8. Defer taxes • Selling securities creates taxable events • Use 401(k) and Roth IRA (if available) • Complications • 15% tax rate on long-term capital gains and dividends • 401(k) and regular IRA distributions taxed at ordinary income tax rates • Use $3,000 capital loss to offset ordinary income

9. Investment expenses • Mutual fund operating expenses and management fees • Loads • Commissions * • Bid-ask spread * • Market impact * *Harder to identify

10. Effect of expenses on returns • Average 7% market return for 30 years • If .15% eaten annually by expenses • $10,000 x (1.0685)30 = $72,985 • If 2.00% annual expenses • $10,000 x (1.050)30 = $43,219 • If 3.00% annual expenses • $10,000 x (1.040)30 = $32,434

11. Selling Magazines • Money, Kiplinger’s Personal Finance, Smart Money, Forbes, Fortune, Business Week, etc. • Range of methodologies • Identifying yesterday’s winners • Buy me • “The 10 Best Funds” • “Annual Mutual Fund Edition” • “Best Funds for Today’s Market” • List of “best” regularly changes: taxes if you switch!

12. Pretty Efficient Markets • Weak correlation between past and future performance • But, lousy funds tend to remain bad • Trying to beat market -> probably do worse than market because of expenses and chasing trends

13. Fundamental Principles • Identify goals and select appropriate investments. • Diversify. • Defer taxes. Keep turnover low. • Keep investing expenses low. Make yourself rich, not the brokers. • Make a plan and stick to it. Do not chase yesterday’s winners.

14. The Magic Bullets: Indexing • Invest in broad indices • MSCI® US Broad Market Index or Wilshire 5000 • Lehman Brothers Aggregate Bond Index • Morgan Stanley REIT Index • Diversified, tax efficient (stocks), and low expenses • Consistently beat most actively managed funds and investors • Use open-end mutual funds or ETFs

15. Open-end mutual fund vs. ETF • ETF = Exchange Traded Fund • Traded on stock exchanges • Arbitrage opportunities keep prices in line with indices • Usually lower expense, but must pay commission • Open-end mutual fund • Your deposits used to purchase more stock for fund

16. Examples: Annual Expense Ratios ETFs • Vanguard Total Stock Mkt VIPERS: 0.07%* • Vanguard REIT VIPERS: 0.12% • iShares MSCI EAFE Index: 0.35% Open-end Mutual Funds • Vanguard Total Stock Mkt Adm: 0.10% (0.19%) • Vanguard REIT Index Adm: 0.16% (0.21%) • Vanguard Total Int’l Stock Index: 0.31% *Average stock fund has expenses more than 25 times greater!!

17. Total Stock Market Index

18. Sample Portfolio for 40 year old • 47.5% - Vanguard Total Stock Mkt Index • 17.5% - Vanguard Total Int’l Stock Index • 5.0% - Vanguard REIT Index • 15.0% - Vanguard Total Bond Mkt Index • 15.0% - Inflation-protected bonds

19. One Stop Shopping

20. Personal Investing 102 • “Value stocks” produce higher returns over time • Low: Price/Book Value • Low: Price/Earnings • Reasonable dividends • “Value and Growth Investing: Review and Update,” by Louis K.C. Chan and Josef Lakonishok, Financial Analysts Journal, Vol. 60, No. 1

21. Add Low Cost Value Funds to Mix • 30.0% - Vanguard Total Stock Mkt Index • 12.5% - Vanguard Value Index • 5.0% - Vanguard Small Cap Value Index • 10.0% - Vanguard Total Int’l Stock Index • 7.5% - Dodge & Cox Int’l Stock (.77%) • 5.0% - Vanguard REIT Index • 15.0% - Vanguard Total Bond Mkt Index • 15.0% - Inflation-protected bonds

22. Tax Efficiency • Put REITS and bonds in tax-deferred accounts • Consider municipal bonds (funds) outside of tax-deferred accounts

23. Recommended Reading • A Random Walk Down Wall Street by Burton Malkiel • The Four Pillars of Investing by William J. Bernstein • Common Sense on Mutual Funds by John C. Bogle • Winning the Loser’s Game by Charles D. Ellis • The Future for Investors by Jeremy J. Siegel • The Intelligent Asset Allocator by William J. Bernstein • Master and use what’s in these books and you will beat most professional money managers

24. Resources • Online mutual fund research (free) • www.moneycentral.msn.com • Library • Stocks: Value Line Investment Survey ($598) • Funds: Morningstar Mutual Funds ($549)

25. One Last Time: Fundamental Principles • Identify goals and select appropriate investments. • Diversify. • Defer taxes. Keep turnover low. • Keep investing expenses low. Make yourself rich, not the brokers. • Make a plan and stick to it. Do not chase yesterday’s winners.